Think Differently: Buying Cheap Stocks is Difficult

“If you want to have a better performance than the crowd, you have to do things differently from the crowd.” –John Templeton

The above quote is one of my all time favorites. It’s a ubiquitous concept: we hear it all the time…. buy what others are selling, buy fear, sell euphoria, etc… The quote represents obvious importance. But the interesting thing is that although it’s an oft used phrase, it is practiced much less often than you might realize. Taking a look at the portfolios of most large investment funds, you’ll find many of the same securities. Some of this has to with the size of some of the funds. If you manage $10 billion, there are only so many stocks you can buy, especially if you have to be diversified.

However, a lot of the similarities come from the fact that it is hard to go against the crowd. It’s hard to buy unknown stocks, and it’s especially hard to buy hated stocks with well-known problems. This is difficult for everyone, amateurs and professionals alike. It’s even difficult for value investors. Many of the value investors today model their portfolios and their investment philosophies after Warren Buffett (for good reason). I also spend an incredible amount of time thinking about Buffett and his methods, and studying his letters. But here is a challenge that we have to overcome: Buffett preaches the benefits of franchise businesses that can compound their net worth over time (for good reason).

Everyone Wants to Own Franchises

The problem is this: everyone understands the fact that it’s a good thing to own a business like that. Thus, the stocks of these businesses are often priced at a premium. Take a look at JNJ, MCD, WMT, KO, or PG just to name a few… these are some of the greatest companies in the world. They almost certainly will have wonderful futures and their stocks will likely be higher years down the road. These stocks are great in permanent portfolios, but I don’t expect them to provide market beating returns over time at the current valuations. They likely will provide market matching returns with less risk, but they won’t give you 20% annual returns over time.

This doesn’t necessarily make them bad long term investments. I simply keep them on a list and observe their valuations during market corrections. I love buying and holding a quality business when the market offers me a price that will lead to above average future returns. But buying and holding a diversified basket of average priced (or in this current market-often overpriced) franchise businesses will not lead to significant long term outperformance. It might lead to moderate outperformance, but it won’t lead to huge returns.

Two Alternative Choices

So if you want abnormal returns, you have to do something differently: you either have to concentrate your holdings like Buffett has done during the course of his career (or like Allan Mecham, when he put 50% of his assets into BRK last year-what a great decision that was at $105K per share)… or, if you want to maintain at least adequate diversification like I prefer, you have to buy stocks that others are selling at cheap valuations. This often means buying cheap stocks with problems. And it’s difficult to do because there are hundreds of reasons why you shouldn’t buy the stocks you’re buying and there are many people who will call you crazy.

Take a look at the comments in any bullish Seeking Alpha article on JC Penney. You’ll find extreme emotion. When people begin hurling insults at an author who merely suggests a contrarian view, it often means that the bad news is already priced into the stock. (I don’t necessarily know about JCP specifically, but this is just a good example of maximum pessimism at the present time).

Difference Between Understanding the Concept and Actually Implementing It

His portfolio may have contained a few big positions in some great companies, but it also would have likely had numerous smaller positions in stocks trading at extremely cheap valuations. His portfolio would also be turning over much faster(he wouldn’t be holding stocks forever, and he didn’t hold stocks forever in his early years-he sold them as they reached fair value to raise cash to invest in more bargains).

To look at a great example of a current investor who thinks differently and also is generous enough to share his ideas, check out Reminiscences of a Stock Blogger. His portfolio is filled with smaller companies, many of them in the natural resource space (the author is Canadian). His portfolio looks a lot different than mine, but it also looks a lot different than everyone else’s also. That’s the key. He thinks independently, and he buys cheap stocks. Notice how it’s worked out for him so far since he’s been tracking his results.

Thinking Independently Works

Other famous examples of investors who thought and acted differently were Buffett in his early years, Walter Schloss throughout his career, Joel Greenblatt, and Michael Burry. They all owned stocks that others either hated or didn’t even know about. They found bargains in a variety of areas using a number of different methods. But the one thing they had in common in addition to buying value was that they thought differently than the crowd. They wanted a better performance from the crowd, and they knew to do so, they had to act differently as well.

2 Responses to Think Differently: Buying Cheap Stocks is Difficult

hi john. excellent article. yes, i am aslo a contrarian. buying stocks with problems needs more courage and it goes against human nature. for these stocks the most important is if the problem is temporary.